China's financial sector was deemed to be reasonably sound before the global economic crisis erupted in 2008. Today, thanks to rising debt, financial stability is seen as the biggest macro risk to China, if not the global economy. The main culprit is China's rigid use of economic growth targets and incentives that encourage overperformance.
Official targets of gross-domestic-product growth play a central role in Chinese policy making. But rather than serving as a forecast of activity for planning and budgetary purposes, these annual targets have taken on the role of seemingly inviolable performance measures. And the mold seems hard to break. Despite indications earlier this year that the official 7.5 per cent growth target was "approximate," Premier Li Keqiang now affirms that it will be met.
In credit-led economies, such growth targets -- combined with incentives to meet and exceed them -- can lead to an undesirable accumulation of debt, and China's growth since 2008 has increasingly been fed by credit creation. The correlation between credit and GDP growth (the so-called credit intensity of growth) has tripled in the postcrisis period to 0.87, up from 0.28 during the previous eight years.
This has led to a potentially dangerous weakening of financial stability. China's ratio of bank credit to GDP has ballooned to 128 per cent at year-end 2013 from 96 per cent at year-end 2008. Standard & Poor's estimates total financial-sector credit at around 200 per cent of GDP.
The continued prominence of GDP growth rates in China's policy framework is a legacy of the old central-planning days, when everyone had a target to meet. Targets were simple to understand and served as a useful rallying point and benchmark for performance. Although today's economy is hardly recognizable compared with that of 30 years ago, old habits seem to die hard.
There is nothing wrong with targets, per se, but China's targeting framework has no memory. It lets bygones be bygones. Past 'mistakes,' such as unsustainable credit growth, are forgotten as long as the current year's target is met. There is no reward for slowing things down to offset past excesses, and the government's view of social stability seems to require that growth be kept at or above the official rate. Clawing back past excessive GDP and credit growth is simply not part of the model.
So how to achieve better results? Start by targeting a certain level of GDP rather than a certain pace of GDP growth. That way, if a country has a credit-driven burst of GDP growth that breaches the GDP target on the upside, then future GDP growth would need to be slower than the original path until the deviation is corrected. This would require lower credit growth and improve the credit metrics.
The good news is that opinions on GDP growth targets in China are already starting to change. There was a level target embedded in the official goal announced in 2010 to double real GDP by 2020. The implied average growth rate would be 7.2 per cent per year, although official pronouncements do not frame this as an (average) growth target.
Several localities have also begun to drop GDP growth as a performance metric. Their justification is slightly different than ours -- in that it focuses on environmental issues stemming from too-high GDP growth -- but the concern over unwanted spillovers of runaway growth is akin to our view.
China's best-case scenario would be to demote GDP growth from an official target to a budget and planning tool, as is done in most other countries. While the government can influence the level of activity through fiscal, monetary and structural policies, it wouldn't be seen as responsible for delivering a specific minimum growth rate.
This is perhaps easier said than done given China's long and dedicated history of planning. But in an era of credit-led growth, until the government takes some bold steps to move away from rigid and asymmetric growth targets, China's financial stability will continue to be at risk.
Paul Gruenwald is Asia-Pacific chief economist at Standard & Poor's.
This article was originally publish on the Wall Street Journal. Republished with permission. Read the original article here.